Thursday, February 4, 2016

ConocoPhillips Cuts Dividends - What Should a Dividend Investor Do?

ConocoPhillips (COP) just announced that it is cutting its quarterly dividend from 74 to 25 cents/share. This comes after management constantly reiterated that the dividend is a priority. Unfortunately, when a company is selling a commodity whose price can fluctuate greatly, and you have very high capital expenditure costs, they cannot really do much other than cut the dividend to conserve resources. This environment is tough on ConocoPhillips, because they are a pure exploration and production play, and have no downstream operations ( refining and marketing) like the big integrated companies such as Exxon Mobil (XOM) and Chevron (CVX). If ConocoPhillips still had Phillips 66 (PSX), it would have been able to weather the storm in oil prices a little easier.
It is also unfortunate that I was right to question the sustainability of the dividend payment from ConocoPhillips in my earlier assessments from 2015.

As I have said before, a dividend cut is an indication that my original thesis is incorrect. When faced with facts that I was wrong, I change my position and I sell. As a dividend growth investor, my goal is to live off the dividends generated from my portfolio in retirement. This is why I favor investing in companies that pay stable and rising dividends throughout the economic cycle. If a company proves me wrong by cutting dividends, this shows that this company is not exhibiting the qualities I look for in an investment.

The question I always get after selling is: “Where should I invest the proceeds from the sale”?
I am thinking of beefing up my position in Exxon Mobil (XOM), which in my opinion will be the one energy company whose dividend will be sustainable. The problem with this decision is that Exxon Mobil looks pricey right now – I would prefer to add to my position at yields around 4%.
The other problem is if we get dividend cuts from other oil majors such as BP (BP) and Royal Dutch Shell (RDS/B), adding to Exxon Mobil will result in an above average exposure in one company. The alternative for me would be to sell those stocks if dividends get cut, and invest the proceeds in an energy funds or ETF.

The rationale for this decision is to retain exposure to the energy sector, during the time of tumultuous dividend cuts. If I sell a stock at a loss, I get to reduce the taxes I pay. If I buy a basket of energy companies, I retain exposure to the energy sector, in case it ultimately rebounds. The funds I am considering include Vanguard Energy ETF (VDE) or Energy Select Sector SPDR (XLE).

The real question to ask of course is whether we are in a new normal, where oil prices stay between $20 - $30 barrel like they did between the 1980s and the early 2000s. If we are in a new normal situation for oil prices, and the whole commodity boom of 2002 – 2008 was just a fluke, then chances are that a lot of energy companies will be in serious trouble, because most of their projections are based on oil selling at two or three times what I may call “the new normal price”. We may see a lot of bankruptcies, consolidations, job losses and terrible spillover effects for entire countries and different industries that supply the tools to oil and gas companies.

Either way, selling ConocoPhillips will reduce my forward dividend income by less than 2%. Reinvesting the money from the stock sold will recover some of the dividend income, and the net impact on forward dividend income will be a loss of 1%. My portfolio allocation to oil majors before the sale was a little over 4% at this moment. It makes sense to retain allocation to the sector, even if all companies ultimately end up cutting dividends, which is where does funds could come in handy in addition to ExxonMobil and Chevron ( whose dividends look "safer" than most others, but not as safe as those of ExxonMobil).

It has been extremely interesting to observe this train wreck unfold in real time however. It looks like most investors and companies have been trying to pick a bottom in oil prices for the past year and half. I am beginning to understand the phrase “catching a falling knife is dangerous”. This of course means that few would have expected that we would have the major producers of oil be stuck in a prisoner’s dilemma where everyone is out for themselves, but ends up hurting their own people along with their competitors. I am of course referring to major oil producing countries which are continuing to pump out a lot of oil, despite low prices. The smart decision for everyone is to reduce production, and everyone will be earning more money. Of course, if the producers with substantial cash reserves play a game of poker where they try to squeeze everyone else, then prices could stay lower for longer. The downside of this game of chicken is that countries are hurting, and this could have negative implications for their economies and people. The other downside is that lower energy prices could translate into lower Capex spending, which could translate into lower revenues for companies that provide goods and services to those oil and gas companies. This would also result in less employment by oil and gas companies, which is not good, because oil and gas jobs are pretty good paying ones. This could also translate into various oil and gas players being unable to meet obligations, which would mean debt restructurings and bankruptcies. This could affect financial institutions, since uncollectable loans affect their profits.

If oil prices do end up rebounding at some point in the future however, and ultimately double or triple from here, companies such as ConocoPhillips will be much more valuable. This is where selling the stock today, getting the tax income deduction, and getting exposure to the energy sector until ConocoPhillips starts raising dividends again could pay off for investors. As I have mentioned before, while I sell immediately when a company cuts dividends, I also consider initiating a position back if the company starts raising dividends again. Of course, as I mentioned in the previous paragraph, no one really knows whether these lower oil prices are under a new normal range, or whether they are finally due for some rebounding.

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